Fair Value of Assets and Liabilities

9 Months Ended

Sep. 30, 2020

Note 7 -- Fair Value of Assets and Liabilities

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements must maximize the use of observable inputs and minimize the use of unobservable inputs. There is a hierarchy of three levels of inputs that may be used to measure fair value:

Level 1Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

Level 2Valuations for assets and liabilities traded in less active dealer or broker markets. Valuations are obtained from third party pricing services for identical or comparable assets or liabilities which use observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in active markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Following is a description of the inputs and valuation methodologies used for assets measured at fair value on a recurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy.

Available-for-Sale Securities. The fair value of available-for-sale securities is determined by various valuation methodologies. Where quoted market prices are available in an active market, securities are classified within Level 1. If quoted market prices are not available, then fair values are estimated by using quoted prices of securities with similar characteristics or independent asset pricing services and pricing models, the inputs of which are market-based or independent sources of market parameters, including but not limited to, yield curves, interest rates, volatilities, prepayments, defaults, cumulative loss projections and cash flows. Such securities are classified in Level 2 of the valuation hierarchy. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy.

Fair value determinations for Level 3 measurements of securities are the responsibility of the Treasury function of the Company. The Company contracts with a pricing specialist to generate fair value estimates on a monthly basis. The Treasury function of the Company challenges the reasonableness of the assumptions used and reviews the methodology to ensure the estimated fair value complies with accounting standards generally accepted in the United States, analyzes the changes in fair value and compares these changes to internally developed expectations and monitors these changes for appropriateness.

Derivatives. The fair value of derivatives is based on models using observable market data as of the measurement date and are therefore classified in Level 2 of the valuation hierarchy.

The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis and the level within the fair value hierarchy in which the fair value measurements fall as of September 30, 2020 and December 31, 2019 (in thousands):

	Fair Value Measurements Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Fair Value		(Level 1)		(Level 2)		(Level 3)
September 30, 2020
Available-for-sale securities:
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	94,866	$	—	$	94,866	$	—
Obligations of states and political subdivisions		232,935		—		232,142		793
Mortgage-backed securities		399,300		—		399,300		—
Other securities		10,126		—		10,126		—
Total available-for-sale securities		737,227		—		736,434		793
Equity securities		185		185		—		—
Derivative assets: interest rate swaps		1,825		—		1,825		—
Total assets	$	739,237	$	185	$	738,259	$	793

Derivative liabilities: interest rate swaps	$	3,574	$	—	$	3,574	$	—

December 31, 2019
Available-for-sale securities:
U.S. Treasury securities and Obligations of U.S. government corporations and agencies	$	107,320	$	—	$	107,320	$	—
Obligations of states and political subdivisions		178,433		—		177,460		973
Mortgage-backed securities		396,126		—		396,126		—
Other securities		3,757		—		3,757		—
Total available-for-sale securities		685,636		—		684,663		973
Equity securities		412		219		193		—
Total assets	$	686,048	$	219	$	684,856	$	973

Derivative liabilities: interest rate swaps	$	325	$	—	$	325	$	—

The change in fair value of assets measured on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2020 and 2019 is summarized as follows (in thousands):

	Obligation of State and Political Subdivisions
	Three months ended				Nine months ended
	September 30, 2020		September 30, 2019		September 30, 2020			September 30, 2019
Beginning balance	$	792	$	970	$	973		$	967
Transfers into Level 3		—		—		—			—
Transfers out of Level 3		—		—		—			—
Total gains or losses:
Included in net income		1		2		4			5
Included in other comprehensive income (loss)		—		—		—			—
Purchases, issuances, sales and settlements:
Purchases		—		—		—			—
Issuances		—		—		—			—
Sales		—		—		(184	)		—
Settlements		—		—		—			—
Ending balance	$	793	$	972	$	793		$	972
Total gains or losses for the period included in net income attributable to the change in unrealized gains or losses related to assets and liabilities still held at the reporting date	$	—	$	—	$	—		$	—

Following is a description of the valuation methodologies used for assets measured at fair value on a nonrecurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy.

Impaired Loans (Collateral Dependent). Loans for which it is probable that the Company will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amount of impairment and estimating fair value include using the fair value of the collateral for collateral dependent loans.

If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value. Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.

Management establishes a specific allowance for impaired loans that have an estimated fair value that is below the carrying value. The total carrying amount of loans for which a change in specific allowance has occurred as of September 30, 2020 was $11,279,000 and a fair value of $9,713,300 resulting in specific loss exposures of $1,565,700.

When there is little prospect of collecting principal or interest, loans, or portions of loans, may be charged-off to the allowance for loan losses. Losses are recognized in the period an obligation becomes uncollectible. The recognition of a loss does not mean that the loan has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off the loan even though partial recovery may be affected in the future.

Foreclosed Assets Held For Sale. Other real estate owned acquired through loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined that fair value declines subsequent to foreclosure, a valuation allowance is recorded through noninterest expense. Operating costs associated with the assets after acquisition are also recorded as noninterest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to other noninterest expense. The total carrying amount of other real estate owned as of September 30, 2020 was $2,220,000. Other real estate owned included in the total carrying amount and measured at fair value on a nonrecurring basis during the period amounted to $9,000.

Mortgage Servicing Rights. As of September 30, 2020, mortgage servicing rights had a carrying value of $1,275,000 and a fair value of $661,000 resulting in a valuation reserve of $614,000. The fair value used to determine the valuation reserve for mortgage servicing rights was estimated using the discounted cash flow models. Due to the nature of the valuation inputs, the following table presents the fair value measurement of assets measured at fair value on a nonrecurring basis and the level within the fair value hierarchy in which the fair value measurements fall at September 30, 2020 and December 31, 2019 (in thousands):

September 30, 2020	Fair Value		Valuation Technique	Unobservable Inputs	Range (Weighted Average)
Impaired loans (collateral dependent)	$	9,713	Third party valuations	Discount to reflect realizable value	0% - 40%	(20%)
Foreclosed assets held for sale		9	Third party valuations	Discount to reflect realizable value less estimated selling costs	0% - 40%	(35%)
Mortgage servicing rights		661	Third party valuations	Discount to reflect realizable value	9.0% - 11.0%	(9.1%)

December 31, 2019	Fair Value		Valuation Technique	Unobservable Inputs	Range (Weighted Average)
Impaired loans (collateral dependent)	$	12,727	Third party valuations	Discount to reflect realizable value	0% - 40%	(20%)
Foreclosed assets held for sale		935	Third party valuations	Discount to reflect realizable value less estimated selling costs	0% - 40%	(35%)
Mortgage servicing rights		1,444	Third party valuations	Discount to reflect realizable value	9.5% - 12.5%	(9.7%)

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements other than goodwill at September 30, 2020 and December 31, 2019 (in thousands).

The following tables present estimated fair values of the Company’s financial instruments at September 30, 2020 and December 31, 2019 in accordance with ASC 825 (in thousands):

	Carrying Amount		Fair Value		Level 1		Level 2		Level 3
September 30, 2020
Financial Assets
Cash and due from banks	$	231,087	$	231,087	$	231,087	$	—	$	—
Federal funds sold		1,298		1,298		1,298		—		—
Certificates of deposit investments		2,695		2,695		—		2,695		—
Available-for-sale securities		737,227		737,227		—		736,434		793
Held-to-maturity securities		10,015		10,162		—		10,162		—
Equity securities		185		185		185		—		—
Loans held for sale		4,402		4,402		—		4,402		—
Loans net of allowance for loan losses		3,189,930		3,135,406		—		—		3,135,406
Interest receivable		20,228		20,228		—		20,228		—
Federal Reserve Bank stock		9,401		9,401		—		9,401		—
Federal Home Loan Bank stock		5,450		5,450		—		5,450		—
Financial Liabilities
Deposits	$	3,619,836	$	3,625,297	$	—	$	3,112,796	$	512,501
Securities sold under agreements to repurchase		170,345		170,349		—		170,349		—
Interest payable		1,838		1,838		—		1,838		—
Federal Home Loan Bank borrowings		93,954		97,174		—		97,174		—
Junior subordinated debentures		18,985		14,235		—		14,285		—

December 31, 2019
Financial Assets
Cash and due from banks	$	84,154	$	84,154	$	84,154	$	—	$	—
Federal funds sold		926		926		926		—		—
Certificates of deposit investments		4,625		4,625		—		4,625		—
Available-for-sale securities		685,636		685,636		—		684,856		780
Held-to-maturity securities		69,542		69,572		—		69,572		—
Equity securities		412		412		219		—		193
Loans held for sale		1,820		1,820		—		1,820		—
Loans net of allowance for loan losses		2,666,616		2,622,053		—		—		2,622,053
Interest receivable		15,577		15,577		—		15,577		—
Federal Reserve Bank stock		9,401		9,401		—		9,401		—
Federal Home Loan Bank stock		4,105		4,105		—		4,105		—
Financial Liabilities
Deposits	$	2,917,366	$	2,924,144	$	—	$	2,332,866	$	591,278
Securities sold under agreements to repurchase		208,109		208,016		—		208,016		—
Interest payable		2,261		2,261		—		2,261		—
Federal Home Loan Bank borrowings		113,895		114,510		—		114,510		—
Other borrowings		5,000		5,000		5,000		—		—
Junior subordinated debentures		18,858		15,596		—		15,596		—

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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